Profiting From Market Risk

In Against The Gods Peter Bernstein writes about how bell curves that be used to predict pricing in the stock market. When I first read this, I thought it was pretty wacky. But when you look at the normal distribution of pricing in weekly, monthly, and yearly terms, the prices do indeed follow a bell curve.

Now, why does this matter? Because you can see what price action is like historically and see that in the long run, the stock market generally goes in the direction you probably want it to (hint: up).

I won't pretend to be an expert in risk and distribution curves, but there is some very interesting information that can be gleaned from a few of the graphs he presented in his book. Here are monthly, quarterly, and yearly price percentage changes. As you can see they do follow a bell curve.

You can say "so what, these are from a long time ago, and you'd be very wrong, but here is a more recent bell curve of yearly and 10-year prices.

I'm all about useable information so I won't bore you with more information on bell curves, but I will talk about what this information reveals. If you look at the top of the bell curve, you will see that each chart at every time scale has a positive number at the top of the bell curve. Obviously, this doesn't mean that you can't lose money in the stock market, you can. But it does mean that on average the stock market goes up.

When you look at the average return of the S&P 500 (from 1928)and the TSX Composite (from the '60s to the present )you get 9.6% and 9.3% respectively. This is a good number, it means on average, just parking some dough in either of these indexes will double your money every 7-8 years or so, not too shabby. It also means you have to live with the ups and downs of the market in general.

One quote from Bernstein that really stood out to me was this: "As it happens, 33 of the 840 monthly observations, or about 4% of the total, were more than two standard deviations away from the monthly average of +.6%-that is, worse than -11% and greater than 12.2%. Although 33 super swings are fewer than we might expect in a perfectly random series of observations, 231 of them were on the downside; chance would put that number at 16-17. A market with a built-in long-term upward trend should have even fewer disasters than 17 or 17 over 816 months.

At the extremes, the market is not a random walk. At the extremes, the market is more likely to destroy fortunes than to create them. The stock market is a risky place."

This was really interesting to me. I love me some volatility because, without the swings in the market, good prices don't show up. To the layperson, buying a stock and seeing it go up constantly is the ultimate goal. But to a successful investor, this isn't the case. These massive downswings are often caused by minor events that do not alter the intrinsic value of a business. This means that these downswings can give an intelligent investor the opportunity to buy great business at fair or wonderful prices and increase their returns over time.

A simple way to think of this is if I was going to sell you a 10 dollar bill. Would you rather buy this 10 dollar bill off of me for 5 dollars or 2 dollars? Clearly, you'd choose the lower price because once it reaches the intrinsic value you've achieved a 5x on your money vs a 2x on the higher price.

There have been 28 market corrections with an average decline of -13.7% since 1945. That's one correction every 2.8 years. They can and will happen no matter how euphoric the market gets, the question is, how will you deal with it?